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Don't bet on a European recovery yet

September 16, 2013: 5:00 AM ET

U.S. investors poured $65 billion into Europe during the first half of the year with the hope that the continent is poised to rebound. Is it?

By Cyrus Sanati

euro-620xaFORTUNE -- Investors betting on a strong economic recovery in Europe may need to rethink their strategy.

Steep and surprising declines in industrial production, along with continued high unemployment, show that the continent's economy is still stuck in the mud. Bad policy and a lack of leadership on both the national and EU level, continues to harm the continent's ability to get back up on its feet. Europe's troubles are existential in nature and require bold and sweeping changes at all levels of government to ensure a strong and lasting economic recovery. Until Europe's leaders are willing to make the tough changes necessary to get things back up and running properly, the continent's economy will continue to degrade.

There has been a sharp change of sentiment on Wall Street and in the City of London towards Europe. Ever since the continent showed a smidgen of positive economic growth in the second quarter of the year, money managers have been pouring billions of dollars, pounds and euros into European investments on the hopes of cashing in on what some believe could be a major economic turnaround.

Indeed, investors in the U.S., led by major pension and mutual funds, have invested some $65 billion in European equities during the first half of the year, the highest such dollar amount in 36 years, according to research from Goldman Sachs.

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To be sure, not all that money has flowed into Europe because investors are keen on the continent's growth prospects. Some of it has come from managers who have been frantically pulling their cash out of emerging market investments, which haven't done so hot this year, and dumping it in more mature markets.

Nevertheless, a great deal of that cash has moved into Europe intentionally on the belief that the markets there are set for a major rally. Many portfolio managers are still kicking themselves for missing the sharp recovery in U.S. equities that took place just six months after the collapse of Lehman Brothers five years ago this month. Those funds that took the risk and bet big on U.S. financial stocks during those dark days reaped massive returns over the next two years as the U.S. government shoveled tons of cash into its banking system. The U.S. economy recovered far faster than many had anticipated and outpaced traditional economic indicators that remained sour well after companies started pumping out strong profits.

It is tough missing out on a major rally because of fear. After all, as the saying goes, "fortune favors the bold," right? Given the amount of money that has flowed into the continent this year one would think that it was a sure bet -- but, of course, it isn't. Indeed, the economic recovery that some believe is taking place across the 17-member eurozone is looking more and more like a sham.

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Last week, European markets collectively gasped in horror when it was revealed that industrial production across the eurozone for July fell 1.5% compared to the previous month. The consensus was for a flat number, meaning that the consensus was off -- way off.

This sort of error in consensus isn't supposed to happen to such a massive degree. Academics were caught off guard and couldn't truly explain why the number was so low and so off. There was an immediate knee-jerk sell-off in European equities but the sentiment on most trading desks was that of confusion, which has carried over into Friday's trading.

So how did this happen? A deeper look into the numbers shows that Germany, the eurozone's largest member, posted a terrible 2.3% decline for the month. Being the eurozone's largest economy, its sharp decline contributed greatly to the overall negative number. But euro boosters claim that Germany is supposedly leading the continent out of recession. This, at least at the moment, appears not to be the case.

There is another camp that believes that the real growth will come from those countries that were beaten down, the so-called peripheral eurozone nations. But Ireland, which has been held up by the EU and investors as the inspirational turnaround story of the crisis, saw its industrial production fall a mind-blowing 8.7%. That was followed by Portugal, which experienced the strongest growth in GDP among all 17 members of the eurozone during the second quarter, posting a 3.2% decline.

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It gets worse. Of all the five categories of industrial production surveyed, the one that experienced the largest decrease was capital goods, down 2.2% across the zone. This decline shows that businesses aren't as confident in the future as investors seem to be as they aren't investing in the tools necessary to increase economic output. European bulls took this information particularly hard as they had relied on a firming of the purchasing managers index (PMI) to justify their belief that confidence among businesses in the eurozone was going up.

It is tempting to disregard this report and continue up the happy mountain with the rest of the herd, but to do so would be a mistake. These industrial production numbers aren't a fluke, they are indicative of the confusion and the political and economic disarray that continues to haunt the continent in the wake of the sovereign debt crisis. The underlying causes of that crisis, namely, high sovereign debt and weak economic output, remain in full force today. Indeed, sovereign debt levels remain off the scale and unemployment continues to inch upward across the board. Several eurozone nations, including France and Italy, continue to run budget deficits well in excess of 3%. That means they are adding to already massive debt loads, thus making them a riskier bet. That would be understandable if their governments were doing something to reverse this trend but they aren't. Indeed, both are making things worse.

It is tempting to bet on the eurozone. The recent 0.3% bump in GDP during the second quarter was the first such increase after six depressing quarters of negative growth. But the subsequent rally in the European markets have gone too far with new highs based solely on speculation, not economic fact.

Europe is still very sick and there is plenty of data proving it. The decrease in industrial production shows that the continent's structural issues continue to hold it back from the brink. Europe may very well solve its economic and political problems and emerge stronger than ever – but it's hard to see that happening anytime soon.

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